Chapter 1, Introductory Cases Dublin Small Animal Clinic, Inc. 1 page; introductory

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  1. Asher Associates: Acquisition Targets

10 pages; advanced





This case includes information from offering documents for two software firms that an Executive MBA candidate is evaluating for a possible acquisition. The information includes detailed financial information, plus add-backs to adjust reported net income to EBITDA, since the owners of both firms are offering their firm for sale as a multiple of EBITDA.

Many privately held firms have high costs for executive salaries, travel, entertainment, automobiles, and similar items that would be substantially reduced by a new owner. The first firm adds back numerous costs but many of them seem necessary to operate the business.

The first firm also expects the acquirer to pay the current owner for 70% of the cash and 80% of the accounts receivable retained in the business (or have the owner withdraw those amounts prior to the acquisition). Sellers and buyers typically specify the net current assets that will remain in the business at the time of the sale; this adjustment effectively specifies that the acquired firm will probably not have enough cash or receivables to operate without additional funding.

The second firm is an “S” corporation so it will be an asset sale. The acquirer will be able to record as intangible assets the difference between the selling price and the net book value of tangible assets, and then amortize that amount over 15 years. That clearly adds value to the acquired company.

The second company also reports on the cash basis, although from the case it is unclear whether the firm can legally use that method for tax purposes. From the potential buyer’s perspective, that is irrelevant because the buyer will switch to accrual accounting. However, there is a very significant issue related to the cash basis accounting. The firm’s financial statements do not include credit sales and at the time the business is being offered for sale, receivables are very high. That leads to two questions. First, are the receivables collectible? From the case, that does not seem to be a problem. The second question is more of a problem.

The firm did not record accounts receivable for prior years. The firm’s owner recently estimated year-end receivables for prior years so the firm could prepare accrual-based income statements. Those accrual statements show a firm with steadily increasing revenues and profits; in contrast, cash-based income statements show a firm with slowing increasing revenues and declining profits. Because the firm has no records of year-end receivables, the potential buyer has no way to know which set of financial statements is more reliable. Hiring a firm to perform due diligence might help, but the results would still be questionable.

The case presents information that is similar to what a buyer would encounter when evaluating businesses that sell for between $10 million and $50 million (and possibly much larger businesses). Sellers know that buyers often price a business based on EBITDA, information is often of questionable quality, and sellers often adjust EBITDA so as to improperly inflate a firm’s offering price.

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